“Capital budgeting is a planning process used to determine whether an organization’s long term investment projects are worth the funding of cash through the firm’s capitalization structure (debt, equity or retained earnings)” (Gervais, Heaton & Odean, 2011, p. 1737). Resources are naturally scarce. Therefore, proper allocation should be done. The main aim of capital budgeting is to make the company more valuable to the shareholders.
In most cases, the cash inflow of a project is compared to its cash outflow. The comparison helps to determine whether the cash generated in the project meets the requirement of the company. The requirement in this case is whether the project will yield returns. There are various capital budgeting techniques employed in determining whether a project will yield good returns to the company. Commonly used capital budgeting techniques include Net Present value (NPV), Payback period, Profitability Index (PI), and Internal Rate of Return (IRR) (Zimmerman & Yahya-Zadeh, 2011).
Capital budgeting techniques
Payback period (PBP)
“This method gauges the viability of a venture by taking the inflows and outflows over time to ascertain how soon a venture can pay back, and for this reason PBP (or payout period or payoff) is that period of time or duration it will take an investment venture to generate sufficient cash inflows to pay back the cost of such investment” (Zimmerman & Yahya-Zadeh, 2011, p. 258). Its calculation involves dividing capital investment by net annual cash flow. There are cases where the net annual cash flow is not the same. This method is advantageous where the company is planning to operate for a certain time, i.e. it has a specific period, but its weakness is that it does not show profits to be generated by a venture. The time value of money is also not considered.
Net Present Value (NPV)
“This method ascertains the net present value by deducting discounted outflows from discounted inflows to obtain net present cash inflows” (Gervais et al, 2011, p. 1738). Net present value discounts outflows and inflows. In this method, the rate that is selected is equal to cost of finance or acceptable by the managers. The rate will be used to discount outflows and inflow where the net present value will be equivalent to the present value of the outflow subtracted from the present value of inflow. Strength of NPV is that it recognizes the time value of money and all the cash inflows for the project in its calculation. The method ignores implicit cost and payback period. Being difficult to use is also another weakness of this method.
Profitability Index (PI)
This index compares costs and benefits of new projects. Comparison is done using ratios. The lowest acceptable ratio is 1.0. “Its strength is that it acknowledges the time value for money, and the NPV of a venture at its present value, which is consistent with investment appraisal requirements” (Gervais et al, 2011, p. 1739). This method is only applicable when cost of finance is uncertain. It also does not give economic life of a project. PI uses the following formula:
Internal Rate of Return (IRR)
Internal rate of return applies the same principle of net present value, that is discounted cash flow technique. “It is defined as the rate, which equates the present value of cash outflows of an investment to the initial capital” (Gervais et al, 2011, p. 1740). The advantage of IRR is that it relates to shareholders’ wealth maximization goal and it considers the time value of money. However, the IRR is difficult to use, and it sometimes gives multiple results. The technique is calculated using the following formula:
C = Cost of investment
A = Inflow for the period.
Gervais, S., Heaton, J. B., & Odean, T. (2011). Overconfidence, compensation contracts, and capital budgeting. The Journal of Finance, 66(5), 1735-1777.
Zimmerman, J. L., & Yahya-Zadeh, M. (2011). Accounting for decision making and control. Issues in Accounting Education, 26(1), 258-259.